Peeling away financial reporting issues one layer at a time

Could Wells Fargo be the Next Big MD&A Enforcement Action?

The question occurred to me after reading Francine McKenna’s coverage of Senate hearing testimony by Wells Fargo’s CEO about the nearly 2 million unauthorized credit card and savings account openings.  I don’t know if the SEC is building an enforcement action against the company, but I am going to tell you why it ought to be.

A Slam Dunk?

There are numerous aspects of SEC filings that could trigger disclosures concerning the unauthorized account openings.  At the top of the list would be MD&A, arguably the most principles-based of all financial reporting requirements, supplemented by extensive interpretive guidance and an impressive string of object-lesson enforcement actions.

Companies often produce lengthy MD&A disclosures from core requirements that boil down to two criteria:

  1. As of the time of filing, what management knows.
  2. Whether a transaction, event or uncertainty that management does know about had, or is reasonably likely to have, a material effect on profitability, liquidity or capital resources.

As indicated by the following from Ms. McKenna’s article, the first criteria would have been met more than a year ago:

“Stumpf testified management and the board was informed of the issues in 2014. The Los Angeles City Attorney filed a lawsuit against the bank in 2015 after Los Angeles Times first published reports of the problems in 2013.”  [italics supplied]

Even so, no disclosure was made in an SEC filing until the second quarter of 2016.  And just in case you are wondering, the MD&A rules do not permit a company to omit required MD&A disclosures out of concern for their effect on future litigation, creating a competitive disadvantage, or a self-fulfilling prophecy.

To the best of my knowledge the first recognition of a potential loss came in Wells Fargo’s June 30, 2016 10-Q, in which it is purported to have accrued a liability for damages and penalties for about $185 million — more or less the amount it eventually settled for — without any disclosure in the filing that the “accrued expenses and other liabilities” balance sheet line item of $77 billion included the $185 million.

$185 million could be pretty small change for a banking behemoth, but there is more to assessing materiality than just a comparison of numbers.   Two landmark cases are relevant to a broader materiality consideration for MD&A:

  • In TSC Industries v. Northway, Inc. (1976), a material fact is one where there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” [italics supplied]
  • Basic Inc. v. Levinson (1988) expanded on TSC with regard to uncertain future events: “Where…the event is contingent or speculative in nature, it is difficult to ascertain whether the “reasonable investor” would have considered the omitted information significant at the time…Materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” [italics supplied]

The $185 million expense accrual was only one of many of the facts and uncertainties known to Wells Fargo’s management since 2013. Nobody could fail to note the significance of the illwill created not just by the opening of unauthorized accounts, but by the subsequent actions — or inactions — of Wells Fargo’s management after learning more and more about the depths of this fiasco over time.

Trust, more than anything else, is what any bank sells to its clients, large and small.  It is impossible not to be appalled by the “total mix” of the circumstances — starting with the working environment that drove low-level employees to desperate measures, the absence of internal controls, and the behavior of the Wells Fargo executives.  It has given rise to what may well be the worst public relations fiasco in the history of the company, and is sure to be the topic of business school case studies for a long, long time.

Therein lies the MD&A materiality assessment: the damage to the Wells Fargo’s reputation as a trusted counterparty, services provider and financial adviser.  How many of Wells Fargo’s current clients have curtailed or terminated its business with the bank?  How many potential clients think, as do I, that they wouldn’t even consider transacting with Wells Fargo unless the investment terms were so favorable that they were simply impossible to resist — and perhaps nearly impossible for the bank to profit from?

Moreover, Wells Fargo stock appears to have dropped about 9% on the news of the revelations, which seems to say that investors are thinking along these same or similar lines.

In summary, the MD&A disclosure criteria are a slam dunk.

Slap on the Wrist, or Real Sanctions?

There is already a long list of cases dating back to the 1990s in which the SEC has imposed sanctions for failure to disclose material uncertainties.  Caterpillar, America West AirlinesSony, and Bank of America easily come to mind.  The BofA cases recently produced about $125 million for the SEC, but every other case that I know of amounted to little more than a slap on the wrist.  None of the cases (including BofA) included admissions of guilt or personal fines.

I can easily imagine how CEOs of companies like Wells Fargo plan their evasion of the SEC’s disclosure rules.  The monetary fines to the company amount to comparatively little, particularly since no executive pays anything out of their own pockets.  That makes it worth the risk for them to postpone announcing bad news until there has been some opportunity to smooth things over.  And, just to make sure the executives are shielded, they will obtain a ‘legal opinion’ from general counsel that some way, somehow, rationalizes non-disclosure.

The SEC can no longer allow the major parties associated with a slam dunk case against a goliath bank to settle without an admission of guilt.  There are already more than enough MD&A enforcement cases out there for Wells Fargo executives and its lawyers to be fully aware of its disclosure duties.  Yet, they appear to have disregarded them, perhaps, ironically, because past enforcement cases are evidence that the low expected cost of noncompliance justifies the risk.

Future would-be rules violators will not learn much from a Wells Fargo enforcement case if it ends with just a slap on the wrist.  We have arrived at the point where the only way the SEC can effectively curtail blatant disclosure violations is to obtain admissions of guilt that can be used against the company in future private actions; and to target individuals as well as the company.

Wells Fargo doesn’t merely beg to be the next big MD&A enforcement case.  It begs to be the biggest.

1 Comment

  1. Reply Hunter Business School January 23, 2017

    I actually worked at Wells Fargo as a teller and I remember how they pushed credit cards. I didn’t agree.

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